How Many Stocks Do You Need for a Diversified Portfolio?

How Many Stocks Do You Need for a Diversified Portfolio?

There are many opinions on this topic. Here are a few fundamental points to consider, With patience and a methodical approach, you can be on your way to a strong portfolio.

If you're building a portfolio of individual stocks, you've probably considered the question of how many you actually need.

Unfortunately, there seem to be as many answers as there are commentators: well-known investor Jim Cramer recommends five to 10 stocks, but others recommend upwards of 30. Professional money managers are also of little help: the average mutual fund has 90 stocks in its portfolio!

Here are a few things to consider while diversifying your portfolio

Understanding risk

One of the most overlooked aspects of the problem is the subtle distinction between standard deviation, a measure of risk that looks at the volatility of a portfolio, and covariance, which measures the degree to which stocks mirror each other's returns.

Both are important: for example, you might have a very low standard deviation in a portfolio with 50 stocks, but you might also find that together they track a major index almost perfectly. This occurs because there are declining returns to diversifying. At some point, adding extra stocks to your portfolio won't reduce your standard deviation any further, but it could actually feed your covariance. In situations like those, you could have chosen far fewer stocks to get the same results or just bought the appropriate index for less time and money.

Of course, investing isn't strictly a numbers game. Jim Cramer recommends a low number of stocks because he believes that investors should really take the time to choose their stocks, a process that requires considerable time an effort. He makes a reasonable point: if you're going to go through the effort of investing in individual stocks, it would be prudent to truly research your choices and take on only as much as you can handle. Otherwise, you might as well just buy the index.

Investing without proper due diligence also puts you at risk of buying the most well-known stocks at the expense of the most suitable ones. Unfortunately, the stocks in the news tend to be more recognizable and easier to remember, meaning you might be more likely to pick duds with name recognition than a winner no one has ever heard of. Because stocks with media coverage also tend to be larger and belong to the major indexes, you're also putting yourself at risk of essentially replicating the index.

Where to start? How do you invest in stocks - and just how many do you actually need?

The name of the game is patience. You don't need to have a fully-invested stock portfolio from the word go; instead, start small. Pick your first few companies to look into and take the time to do your research. Make sure to pick companies you want to hang onto for the long haul. From there, you can do a bit more research and slowly start building a portfolio.

A key part of this is being comfortable deploying your cash slowly. You can always put the bulk of your portfolio into an index fund while you slowly build your portfolio using new inflows or some of your already-invested capital. Just take your time: this is an undertaking that operates in years and decades, so there's no rush.

Second, remember that context matters. Don't just pay attention to the individual company you're researching, also think about its industry, index participation, and geography and, most importantly, how it fits in with the other holdings in your portfolio. You can have a very well-diversified and powerful portfolio of 20 global stocks of varying sizes and industries, or you can buy stocks that all appear on the S&P 500 and do no better than the index.

To avoid the latter situation, challenge yourself to add investments outside of the size, geography, and industry that your other stocks are in. This will not only make you a more flexible analyst, it will help protect your portfolio from the covariance risk that can undermine even the most enthusiastic attempt at diversification.

With patience and a methodical approach, you can build a strong portfolio with relatively few stocks over time. Because at the end of the day, there's no magic number of stocks that make a diversified portfolio. It's not the number that matters: it's the quality of the names you choose and their relationships to each other. Aim for good companies that operate in different places and industries, and you'll be off to a very strong start.

By Anna Wroblewska